Alternative Strategies for Resolving the European Debt Crisis
Paper prepared for Resolving the European Debt Crisis, a conference hosted by the Peterson Institute for International Economics and Bruegel, Chantilly, France
The European debt crisis poses a severe challenge to the European and global economies. The crisis has spread from its original epicenter in Greece to Ireland and Portugal and, most recently, to Spain and Italy. This paper examines two categories of policy options for dealing with the crisis. In the first, a menu of approaches is considered for dealing with liquidity and, potentially, solvency problems for these sovereign debtors. In the second, three major institutional changes are considered that could affect the outcome: expansion of the European Financial Stability Facility (EFSF); allowing the issuance of eurobonds jointly and severally guaranteed by eurozone member states; and, as a more extreme possibility, exit from the euro by a country or number of countries.
The discussion first examines the severity of the debt problem in each of the five economies. The central framework is that of “debt sustainability.” The main question is whether the country is on a fiscal path that will cause debt to spiral out of control or whether instead the debt burden relative to GDP can be held to, or brought down to, manageable proportions. A key diagnostic is a debt sustainability equation that calculates the size of the primary (non-interest) fiscal surplus that must be achieved to keep debt from rising relative to GDP. This equation states that this surplus, as a percent of GDP, must equal or exceed the excess of the interest rate over the nominal GDP growth rate, multiplied by the initial debt ratio (so the necessary surplus is higher if the initial debt ratio is higher). The discussion for four of the countries focuses in part on this required primary surplus. The analysis for Greece goes into greater detail, drawing on Cline (2011).
Beyond the solvency question addressed by this debt sustainability diagnosis, there is the question of liquidity. For this purpose the discussion considers magnitudes of amortization coming due. The existing support programs for Greece, Ireland, and Portugal are examined in light of these liquidity needs. For Italy and Spain, the broader question is raised regarding whether expansion of the EFSF, or other approaches, are necessary to ensure liquidity even if solvency seems plausible.
The analysis concludes with consideration of a matrix of impacts by policy approach and country, adding the implied effects for France and Germany as the main lender-of-last-resort economies. One such matrix is identified for country publics and governments of the seven eurozone economies considered and also for the rest-of-G7 (on a heuristic basis rather than being quantitatively estimated). A second impacts matrix is identified for the banks of the corresponding countries. The patterns of suggested impacts may help diagnose how policy decisions would be likely to play out, and thus to provide a point of reference for the simulation game carried out on the second day of this conference.
The overall thrust of the analysis here is that the European debt crisis is one of confidence and the maintenance of liquidity, rather than one of deep insolvency. Even for Greece the finding is that debt should be sustainable if the central expectations of the Greek adjustment packaged agreed in July 2011 are attained. Even so, an ambitious primary surplus will be required. For Ireland and Portugal the solvency condition should also be met, although liquidity strains might require going beyond the present arrangements toward one involving private sector involvement (PSI) more similar to that in the recent Greek package. Solvency is also identified for Spain and Italy, but if short-term loss of confidence were to dominate, meeting liquidity requirements could require mobilizing the broader measures of euro-bonds and expansion of the EFSF. The most negative options are found to be deep debt forgiveness or even outright unilateral default. The option of exit from the euro is also viewed as potentially costly, including for a possible strong-country exit group that might seek to form a new currency—especially if public-good valuation of European monetary unity is taken into account.